The set of investors who have invested post 2013 till late 2017 after seeing the good performance of Small Cap funds saw a sharp correction over the last 2 years i.e. February 2018 post budget. Most of the investors who had invested for the first time in equity funds are now wondering that if they should exit and move their investments in fixed deposit type of instruments or look for only quality stocks to invest or only quality balanced mutual funds.
Small cap equity funds are those which invest in shares of companies which have smaller market capitalisation and invest in the 251st company onwards in terms of full market capitalisation. In such a fund, the fund manager needs to have a minimum exposure of 65 per cent to such companies. The balance 35 per cent can be in mid-, large- or small-cap companies depending on the view the fund manager has on the market.
Many market pundits believe the small cap space is where a fund manager will be able to generate higher alpha in the years to come. This is post the Sebi norms on categorization of mutual funds. While only 100 stocks are available in the large cap space, 150 stocks are available in mid cap and over 2,000 in small cap. As many as 30-40 analysts cover a large cap stock, in the BSE Small Cap index there is a dearth of analyst coverage. Many stocks are not covered by analysts, leaving a lot of scope for fund managers to generate alpha.
Small cap funds carry higher market risk when compared to other categories like large- or mid-cap funds. Investors with the ability to digest higher risk and with a longer time frame of 7-10 years could look at investing here. Wealth managers suggest investors must have a small portion of his/her portfolio allocated to small-cap funds. One of the best ways of investing in this segment of the market to reduce risk could be using systematic investment plans (SIP) as that would stagger your investments over a period of time. Small-cap equity funds can be ideal for investors who may have long-term goals like planning for children’s education, saving for retirement, Historically, these funds have delivered higher returns as compared to the benchmark.
However if you look at the history of stock markets over the last 20 years situations like these where stocks have not performance for few months have occurred multiple times in the past in equity funds. However, history tells us that after every steep correction it strongly bounced back and made wealth for investors provided the quality of companies in the particular fund has invested is sound and companies invested there in are growing in the expected earnings.
While in the last two years, small cap funds have not performed well, but it is a short term correction and such correction has occurred many times in the past and every time it strongly bounced back from such deep correction.
All small-cap funds do not permit lump sum investment. Depending on the fund manager’s view on the market and the assets he can manage. Once the fund reaches a particular size, the fund manager may close it temporarily for high-ticket lump sum investments and allow only SIPs. Hence if you are keen to invest in a small cap fund only allocate a part of your portfolio which you can consider subject to higher degree of risk and it maybe an ideal time to start the same with an SIP which could enhance your portfolio returns when market will bounce back. Also, you can take the advantage of such corrections by investing lumpsum at discounted prices in those stocks (Small cap fund portfolio) which may deliver better risk adjusted returns in future. However if you are a new investor or you do not have a very high risk appetite and a longer investment horizon (minimum of seven to 10 years), it is better to stay away from small cap mutual fund schemes. Small cap mutual fund schemes are meant for aggressive equity investors who can stomach a lot of volatility and risk.
(The author Rishabh Adukia is a Chartered Accountant and qualified professional advising on wealth management to individuals, millennia’s, emerging HNIs including others and can be reached on firstname.lastname@example.org )